Thursday, 13 March 2014

DAR’s Exchange Rate Policy

Article was published in the "Money Matters" March 17, 2014.        tweets @malikemal
While teaching an international finance course to my students at the PIDE, several questions surfaced regarding the gap between the theory we teach and the current scenario of exchange rate of the rupee that has appreciated against the greenback from Rs108.64 on December 3, 2013 to Rs97.88 on 12 March 2014. On the one hand, prominent economists have rubbished the recent appreciation and termed it an overvalued exchange rate, while on the other hand our finance minister, who is currently obsessed with reducing the exchange rate, believes the rupee’s appreciation indicates the revival of public and investor confidence in the economy and the local currency.

Two basic theories which explain movements in the exchange rate in the short to medium run are uncovered interest parity (UIP) and purchasing power parity (PPP). Uncovered interest parity says that movements in the exchange rates are due to the difference between interest rates offered in the home and foreign country. Exchange rate adjusts according to the interest rate differential during the maturity period of bonds.

The purchasing power parity theory says that the exchange rate is the ratio of domestic price and foreign prices. If prices in the home country are more than foreign country then the exchange rate depreciates and vice versa if foreign prices are more than domestic prices. Thus, it clearly states that changes in exchange rate between the two countries is directly proportional to the inflation differential between the two countries.

Daily fluctuations in the exchange rate depends on various factors which are mostly related to the “news”. Some people call it speculation but not every news story is speculative, sometimes it is based “anxiety” and “expectations”. I am using the word “anxiety” because, in general, forex investors have a myopic view and they do not want to take any kind of risk. We can call them over obsessed risk averters.

These news stories or reports are nonetheless related to the availability of forex reserves in the market. For instance, expectations of excess supply appreciate the exchange rate and expectations of excess demand depreciate the exchange rate. These expectations are sometimes correct and sometimes create havoc in the market. The current appreciation in the exchange rate from Rs. 104/$ to Rs. 98/$ is a special case of speculation which is explained by several authors during the last few days but every argument relates it with higher remittances, lower trade balance, better reserves management but it is beyond that. The latest report in the market is that Pakistan received $1.5 billion from the two friendly countries for a special purpose. The news may be true but I don’t buy the argument that $1.5 billion has resulted in the appreciation of rupee by 7.2 percent in 12 days.

Oil imports bill account for one-third of the total imports bill. The government is now using FE-25 facility to finance imports for a 40-day period. This ensures lesser depletion in forex reserves held by the SBP temporarily. More importantly, it gives imports a cover and puts less pressure on the exchange rate due to large inflow of forex reserves held by the SBP. It helps the government manage forex reserves more efficiently.

Although the above stated arguments are important in the exchange rate management but I failed to associate the current appreciation during the last ten days with the actual happenings discussed by the authors in various newspapers. The only logical thing which can be associated with it is political gimmick. But how?

It is surprising to see government officials over joyous about the current appreciation. It is no surprise either that the government has taken credit for the rupee’s rise or conveniently termed it an achievement of the government. Several repercussions are expected due to the appreciation in the nominal exchange rate. On the positive side, the inflation rate will decline due to a decline in the import bill in rupees. Subsequently, the government may also reduce the price of oil – a move that will help industrialists purchase cheaper raw material, intermediate goods and capital for their production. Moreover, imported consumer items will be available at lower cost. But here we are forgetting that prices are sticky downwards. Other than oil prices, which are controlled by the government, prices of other commodities may not decline. Nevertheless, they are not going to increase as well.

Theories of exchange rate determination discussed earlier clearly state that in the presence of inflation differential, which is positive for Pakistan, the exchange rate needs to depreciate. Nonetheless, prices do not affect the exchange rate instantly but with a lag of six months to three years in some cases due to several factors – central bank intervention being the most important among them. Similar behavior was observed in the last decade when the exchange rate was artificially controlled. Some authors call it a stable exchange rate but they ignore that the real effective exchange rate is overvalued, which really matters in terms of policy formulation and competitiveness.

And while the IMF has approved our EFF loan, several prominent economists, including ones in the IMF have been arguing that our exchange rate is overvalued and needs to depreciate thus we should not intervene in the market and try to “stabilise it”. Stabilising the nominal exchange rate implies that we are changing the value of the real exchange rate from its equilibrium.

The current appreciation will increase the import bill (in dollars) because imports are now cheaper and exports will decline (in dollars) because exports are now expensive. Selling one dollar worth of exports in the international market was giving Rs105 at the start of this month but now they will get Rs98 for the same thing. Thus our exporters are bearing potential loss of Rs7. Is it good for the economy? Not at all.  Moreover, if the trade balance gap widens then it will directly affect the current account balance.

Further, one must ask whether the Pakistani currency is appreciating only against dollar or it is appreciating against other currencies as well. The answer is yes, it has appreciated against the Euro by 5.3 percent from March 3, 2014 to March 12, 2014. Similarly, it has appreciated 7 percent against the Chinese Yuan and 8 percent against UK Sterling in the same period.

While communicating with several economists and students of economics, I realised that everyone is expecting the rupee’s revaluation to be short-term, most expecting it to go back to Rs106 or Rs109 against the dollar. Nevertheless, no one knows the time frame, which is the most important thing. Since Finance Minister, Ishaq Dar is expecting $16 billion forex reserves by the end of this year, the government gets a cover by financing imports through banks, Further, the finance minister has asked the US to reimburse Pakistan for the remaining CSF payments, ensuring better forex reserves management while controlling the current account balance. The exchange rate may not depreciate much by the end of the year but this does not imply that our competitiveness is improving or our economy is thriving.
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